Oil Could Drop to $87 in the Short Term: Charts

The International Energy Agency (IEA) dumped 60 million barrels of Government oil hoarded in the strategic reserve. Half of this comes from the US strategic reserve, which holds around 727 million barrels of crude. The last time this type of market intervention occurred was in 2008 when oil was trading at $147/barrel.

After Hurricane Katrina in 2005 oil stocks were also released, leading to a 20 percent drop in oil prices in the following two months.

The current intervention is a drop in the ocean, but it’s a body blow to the price uptrend, which has been in place since June 2010. It drives prices back towards long-term support around $87/barrel.

Lower oil prices provide instant relief from inflation – despite recent Government denials that the increase in oil prices were inflationary. A drop in prices at the pump hands consumers more income. It’s almost like a tax cut.

This is not a long-term policy solution. Drawing down on stockpiles is a policy with a clearly defined end. This can only last as long a stockpile inventories last and the market knows this. Nobody is going to fade this trend right now, but it’s a sucker-punch trade in a few weeks time when the release comes to its inevitable end.

Chart analysis helps to identify the support levels and the rebound target levels. This sets up both a short-side trade, and later, lays the foundations for a trade from the long side to capture the rebound rally, and potentially the beginning of a new longer-term uptrend.

There are two significant features on the NYMEX oil chart . The first is the consistent support and resistance bands. These define oil price activity. The second feature is the long- term uptrend line that started in June 2010. This trend line has been broken on the downside. A natural market rebound from the trend line, acting as a support level, did not develop because it was overwhelmed by market intervention with the IEA release of strategic oil reserves.

This signaled a short-side trade driven by external policy decisions. The downside target is the long-term support level near $87/barrel. If this fall was triggered by changes in the fundamentals of demand and supply then the chart would also suggest a further downside target near $77/barrel. This is a low probability target simply because the new supply of oil is limited by the size of the stockpiles and the political will power of the IEA member nations.

This is very different from OPEC intervention in the market where their virtually ‘unlimited’ supply allows for the almost infinite increase in production to meet the demand and supply balance. IEA increases in supply are limited by the very nature of the stockpile. This suggests string support around $87/barrel with the development of a consolidation pattern.

And that’s the foundation of the long side trade. A breakout from the short-term down trend or the short-term consolidation pattern has an immediate upside target near $99/barrel to $100/barrel. When oil is trading below $100/barrel the pattern of support and resistance is consistent. The support and resistance bands are around $10 wide.

The technical upside target for oil was $98/barrel but the psychological resistance target is $100/barrel. When oil moves above $100/barrel the behavior of the market changes. The first change in behavior is an increase in volatility. The price moves up and down more rapidly than when oil is below $100/barrel.

The second change in behavior is an increase in the width of the support and resistance bands. This is now around $12. The first trading band target is measured from the psychological resistance level at $100/barrel and gives an upside target near $112/barrel.

A price rise to $98/barrel to $100/barrel cannot be easily overwhelmed by further IEA releases. A rise to this level signals an exhaustion of the IEA will power to continue to supplement supply. This opens the way to quickly run past $100/barrel and return to the increased width of the trading bands. The only significant barrier is an OPEC decision to boost supply to compensate for the inability of the IEA to maintain supply at higher levels.

The current retreat is an aberration in the fundamentals of demand and supply. The price chart shows the constraints of this policy. A return to the usual demand and supply relationships restores the price activity to its previous behavior and this points the way to a resumption of the uptrend.

Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders –www.guppytraders.com. He is a regular guest on CNBC's Asia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe.

If you would like Daryl to chart a specific stock, commodity or currency, please write to us at ChartingAsia@cnbc.com.

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